# Riding the wave

## high yield

Investors have embraced risk this year and poured into high-yield bonds. So farthey have been well rewarded, with returns of around 15% in the first half ofthe year. Some have seen the junk bond boom as a leading indicator of the USeconomy’s recovery. Others suggest it is moving ahead too fast – asit often has before – and is storing up problems for investors in the mediumterm.

Over $120bn of high-yield bonds were issued by mid-September, according to FitchRatings. In the short term, the bonanza reflects a belief that US corporate creditworthinesshas improved – defaults are down, recovery rates and ratings are up – ascompanies went about cutting costs and cleaning up their balance sheets. Lowinterest rates have allowed a number of struggling companies access to refinancingcapital that is keeping them afloat. But is that just delaying a default furtherdown the line when rates inevitably rise? And to what extent are investors assumingthat the economic growth required for high-risk companies to thrive is just aroundthe corner? At rock bottom What a difference a year makes. On the back of five years of poor performance, 2002 proved one of the worst yet for the US high-yield market. At its nadir last October the average junk bond was trading at around 1,100bp over Treasuries, as investors reeled from dour economic figures and a rash of corporate accountingscandals and defaults. That has been largely forgotten this year. More than$21bn was invested in high-yield funds in the first half of 2003, according to AMG Data Resources – the highest since 1990. A slight blip in July and early August, due largely to profit taking and a spike in interest rates, was rectified in a record last week in August when high-yield funds saw inflows of a stunning $3.3bn. With interest rates at 40-year lows, credit quality ending its decline and spreads tightening, the money is going into increasingly lower-grade issues. So far they have been the best performers. Bonds rated triple-C returned 34% during the first four months of the year, while double-B rated bonds returned over 10%. Bonds in sectors that were ravaged in 2002 have seen the sharpest bounces, notably telecoms (27%) and utilities (34%). In transactions unthinkable in the last few years, triple-C rated issuers like Western Wireless and Cincinnati Bell Telephone have sold out$600m offerings. So far so good. But is this wave of junk bond issuance sustainable?

“ Over the last year we have seen corporates – including high yield – take advantage of lower interest rates by issuing long-term debt while paying down their short-term debt,” says Robert Grossman, chief credit officer at Fitch Ratings in New York. “That was particularly the case last year with high grade; but we are down to triple-C this year. Corporate cashflow is improving, but a lot is to do with lower interest rates rather than improving revenues.”

The ability of companies to refinance in the last year means short-term risk has been pushed out. To avoid default on interest payment, however, companies need revenue and cashflow. Default risk in the year up to August stood at 4.2% compared with the annual average of 6%, says Mariarosa Verde, managing director at Fitch Ratings. “But there is still $100bn in high-yield bonds with ratings from triple-C to single-C; that is a substantial concentration in high-yield securities,” she says. “In order for default rates to fall further and for companies to meet interest rate payments you need growth.” Michael Taylor, high-yield strategist at Bear Stearns in New York, is bullish in the short term and relatively positive in the longer term about the climate for corporate borrowing. He estimates that by the end of the year there will have been$100bn of original high-yield issuance, plus $40bn–$60bn from the ‘fallen angels’. That contrasts with $122bn and$57bn respectively last year.

“The significance of the decline in fallen angel issuance, declining default rates and the improvement in recovery rates, plus the general improved economy, has driven demand for the asset class and issuance,” says Taylor. “Also, of the \$100bn I expect to see issued in 2003, around three-quarters has gone to refinancing existing debt – be it unsecured or bank debt.”

Therefore, contrary to what usually happens when there is an abundance of new supply, it has not put pressure on spreads. Spreads may be down to around 500bp–600bp, about half last October’s average, but Taylor points out that the asset class’s historic low was at 300bp in 1998. “If default rates fall further, you can justify investment in high yield because you are compensated for risk,” he says. “Down the line, companies have done what they should be doing – refinancing. Balance sheets are improving; total debt may not be down but the cost of capital is lower. Therefore companies are set up better for the future and not necessarily going to default.”

He concludes: “Who knows what may happen in the next three or four years? But in the meantime troubled issuers have bought themselves time and that wouldn’t have happened if there was not confidence in the economy.”

Skepticism
Others are less optimistic. A study by Moody’s in June reveals that the credit quality of junk-rated US companies is lower than last year, and estimates a 35% higher probability of default. Moody’s said its risk measure, which it calls the median expected default frequency, had improved significantly for speculative-grade companies but that high-yield investors had become overoptimistic. The firm believes the spreads between junk bonds and Treasuries should be wider than last year.

Diane Vazza, head of Standard & Poor’s global fixed-income research group in New York, suggests that the spike in issuance portends deteriorating credit quality and future defaults. She worries that the share of issues rated single-B minus or below stood at 28% at the end of the first half, compared with 21% in 2002 and 19% in 2001. “The previous spike in low-grade issuance at these rating categories during 1997–1999 subsequently led to a peak in defaults in 2001,” she says. “During this period, the share of speculative-grade companies with issues rated single-B minus or lower consistently exceeded 30%. If this proportion were to exceed the 30% range this year and stay there for a sustained period of time, it would serve as an early warning that the speculative-grade default rate could worsen in three years, which is typically the length of time between elevated issuance and higher defaults.”

At the moment default rates have fallen below 6% for the first time since August 1990, says Vazza. “However these beneficial near-term trends may well be reversed if continued favorable supply conditions – such as increased investor risk appetite, attractive pricing, and heavy inflows into high-yield funds – result in generating more deals of questionable quality.”

Donald Ratajczak, CEO of BrainWorks and Regent’s Professor Economics Emeritus at Georgia State University, sees a parallel with 1992. Just like today, high-yield bonds led the investment pack. He explains: “The first glaring similarity is that high-yield bonds offered more than 10 percentage points more than Treasury bonds with comparable maturities during each of the recessions preceding the surge in bond values. This probably was the result of the second similarity: defaults soared to more than 10% in each recession. The third similarity is that the Federal Reserve appeared to have engineered unusually low short-term interest rates in both periods.”

Significantly at both times, despite little job growth and a sluggish economy, the rate of bond default dropped sharply.

What conclusions then can we draw? Ratajczak envisages falling borrowing costs leading to profit gains, lower defaults, greater access to borrowing, and then the “capital spending that economists still cannot spot”. Second, high-yield bonds will continue to perform well until the interest rate spread and default rates both fall to less than five percentage points. Then will come the impasse: “Once the rally is over, bondholders will be slow to realize how much the flood of new borrowing at high levels of leverage is impacting the market,” continues Ratajczak. “Indeed, an increase in supply ultimately will push rates back up, but not until some companies have acquired too much debt.”

This excess usually occurs two to three years after the large rally. But there’s no need to panic quite yet. That still leaves investors with “another year of very attractive returns before the music stops on this investment opportunity,” says Ratajczak.

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